Woodside Has Bigger Problems than its Failed Oil Search Bid

It hasn’t been a good week for Woodside Petroleum [ASX:WPL]. Australia’s largest oil exporter announced today it was abandoning an $11.6 billion bid for Oil Search [ASX:OSH]. While it comes as a disappointment to Woodside, it might also be the least of its problems.

Last Friday, the Organisation of Petroleum Exporting Countries (OPEC) failed to agree on ways to reduce oil output. That came as a blow to non-OPEC producers hoping for some price relief. In making the decision, OPEC ensured that low prices will dog the industry for some time yet.

For the likes of Woodside, that equals more pain in the short term. Pain that, from what we can tell, has no expiration date.

You’d be hard pressed guessing what the market will look like in six months’ time. When politics drives so much of what’s happening, as is the case with oil, the future is unpredictable. The problem for Woodside is that OPEC is showing no signs of letting up in its strategy.

We can pin the blame on this on the main culprit, Saudi Arabia. As the de facto leader of OPEC, the Saudi’s influence the entire decision making process.

For an organisation that accounts for one third of global supply, what the Saudi’s (OPEC) decides matters. And it’s decided that no price point is low enough for the world.

What’s OPEC’s aim in lowering oil prices?

The problem for oil prices these past two years has been one of rising outputs against falling prices.

OPEC has, and continues to, pump out oil even as prices sink to new lows. When it failed to reach a decision on output levels last Friday, oil prices plunged again. WTI crude is down 6% this week to US$37 a barrel. Brent crude also fell to US$40, down US$20 since June. Compared to June 2011, Brent prices are down 65%. And they could fall further if the Saudi’s get their way.

Saudi Arabia wants to do away with production targets altogether. They reckon that prices would fall even without output limits. And they’re probably right to some extent. But the bigger point here is that the Saudi’s are intent on keeping prices low. They’re showing no inclination that they care about ending the current price glut.

By arguing in favour of no supply limits, the Saudi’s are saying that they want to ramp up OPEC’s total output. They’re placing market share at the forefront of OPEC’s strategy. Even if that means accepting lower oil prices indefinitely.

One of the problems with OPEC is that, while it is a cartel, it lacks the characteristics of a real one. Typical cartels fix prices, but do so for purely business purposes. OPEC operates a little differently.

As you may already know, Iran is one of the 12 OPEC members. This is, of course, the same Iran that vies with Saudi Arabia for Middle Eastern supremacy. Both have an interest in maximising oil revenues. But that’s about as far as the cooperation goes.

When OPEC members get together to decide on output levels, there’s a lot more than business at stake.

It may be true that both Saudi Arabia and Iran want a reduction in output. They just don’t want any cuts to come from their end. Instead, OPEC wants to put pressure on other producers, like Russia, to cut output and lift prices.

Is this fair, or even responsible? It’s not a question of fairness, or responsibility. It’s a matter of practicality. OPEC is in a position to drive oil prices where it sees fit. And it has every right to do just that.

From the Saudi’s point of view, they’ll have reason to believe they’re doing nothing wrong. Capturing market share is their strategy, so why would it feel responsible? As a low cost producer, Saudi Arabia has no interest in slashing output. All it needs is a sign that its market share strategy is working.

To some extent, OPEC has had success in shutting out high cost producers from the market. Sadad Al-Husseini, who worked at Saudi Arabia’s state run oil company, explains:

‘Look at what [Saudi Arabia] have done to the flooding of markets that was going to happen. We’ve seen US$200 billion of projects delayed and high cost production around the world has been shelved. So that’s a great success and if they hadn’t been following this strategy they would have been subsidising very high-cost competing supply which would have just compounded the issue and brought prices down anyway.’

OPEC’s market share strategy has also seen recent success in driving US shale oil producers out of business. Since last October, the number of US oil drilling rigs has declined by two thirds. And while the US shale industry put up a fight at first, OPEC’s persistence is now starting to pay off.

Woodside heading for a rocky 2016

Ultimately, the outlook for the industry is grim. Oil prices are likely to fall further before they rebound. With Iranian sanctions lifted, oil output is set to expand from early next year. Iran could flood the market with another 500,000 barrels a day. So we can say with confidence that OPEC’s market share strategy won’t let up anytime soon.

None of this bodes well for smaller oil producers like Woodside. And it helps explain why Woodside was so keen to expand its asset base. That won’t happen with Oil Search, unless Woodside comes back with a much better offer. But it won’t stop the company from exploring opportunities elsewhere.

As oil prices continue to decline, the pressure on Woodside to expand its own market share will only intensify.

Mat Spasic,

Junior Analyst, Markets and Money

PS: Oil, like other commodities, is having a rough year. Commodity exporters have shed 5% on the ASX since early June. But the situation could get much worse before it improves.

The Aussie share market had its worst month since 2008 in August. The ASX lost 9% of its value, shedding more than $70 billion.

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Vern is the award-winning Founder of TheGowdie Letter and Gowdie Family Wealth advisory services. He’s ranked as one of Australia’s Top 50 financial planners. Vern’s convinced the ASX could lose as much as 90% of its $1.8 trillion market cap. And that’s why he’s written ‘Five Fatal Stocks You Must Sell Now’ for you.

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